Would you bet against Warren Buffett?
Of course not.
If you’ve been investing for any length of time, you probably think of Warren Buffett a lot like I do...a big missed opportunity.
Berkshire Hathaway (BRK-A) looked expensive at $500. Then again at $1,000. Then at $3000 too.
Today it’s more than $225,000 a share.
That’s why Buffett is who he is and why no one bets against him when it comes to the markets.
Well, almost no one.
A hedge fund management group has taken the other side of a big bet with Buffett and they are betting big on one of the hottest new investing trends that has already attracted $500 billion in new capital.
It’s the hottest trend in investing today. And I hope you miss it completely. Here’s why.
Buffett’s Big Bet
Six years ago Buffett and the heads of money manager Protege Partners placed a simple wager.
The bet was for $1 million, ran from January 2008 to January 2018, and was over whether an S&P 500 index fund would beat a fund made up of of a bunch of different hedge funds over that time.
Buffett took the S&P 500, Protege took the hedge funds.
Even though the credit crisis came after the bet was made and gave hedge funds (which can profit when stocks go down if they’re positioned correctly) a head start, Buffett is still way ahead.
At last report, the S&P 500 index fund was up 43% since the start of the bet. The hedge funds were up just 12.5%, after fees.
The problem with this bet -- and the part that would surely make Buffett the easiest $1 million he ever made -- is the big problem with hedge funds.
Their big problem is they are constantly chasing something they call Alpha.
Alpha is a simple thing.
Morningstar states: “In a nutshell, alpha is the difference between a fund's expected returns based on its beta and its actual returns. Alpha is sometimes interpreted as the value that a portfolio manager adds, above and beyond a relevant index's risk/reward profile.”
In other words, if you invest in large cap stocks and earned a 14% return last year and the S&P 500 only went up 11%, well, you got 3% of alpha.
It’s not a complicated concept. But it is pretty challenging to achieve. And time has proven it’s nearly impossible for most hedge funds to achieve any of it.
This secret, however, is out.
And after years of focusing on alpha, the market has moved on to something else new and shiny.
That new and shiny is beta, alpha’s closely related cousin.
Out: Alpha, In: Beta
Beta is the measure of a stock or fund’s price movement relative to the rest of the market.
If a stock has a beta of 1.0, it moves in lockstep with the benchmark it’s measured against, usually the S&P 500.
If the beta is below 1.0, it moves less than the market. For example, let’s say it has a beta of 0.5. This means it would move be expected down 5% if the S&P 500 moves down 10%. It would also only move up 5% if the S&P 500 moved up 10%.
If a stock has a high beta above 1.0, it would move much faster than the benchmark market. A high beta stock with a beta of 3.0 would move up and down three times faster than the S&P 500. A 10% move in the overall market would expect to move the high beta stock 30%.
Beta is a simple theory. But it’s not perfect.
That’s why one of the hottest trends in finance is what’s being called “Smart Beta.”
That has to be better than just “beta” right? It’s smart beta.
Well, despite the slick marketing, smart beta is inherently flawed too. And it will lead to problems just like alpha and beta did before that.
The “Smart Beta” Boom
The “Smart Beta” actually encompasses a number of different investment funds that don’t track the traditional market indices.
You see, most of the major market indices like the S&P 500 and the Russell 5,000 are weighted by market cap.
The result of this weighting is the bigger the company, the more of an impact it has on the overall index.
For example, a 1% move in Apple (APPL) has 70 times more impact than a move in a relatively large company like homebuilder Lennar Corp (LEN).
That’s the flaw in the big indices like S&P 500. And it creates a problem where the best performing stocks end up making up an outsized portion of the index.
It’s a problem “smart beta” funds are looking to exploit.
Smart beta funds look to counteract that inherent flaw. And they do this by looking at a number of other criteria primarily based on stocks with lower beta.
They claim this is a mix of “active” and “passive” investment management and why they’re better than passive buy and hold investing.
In the end, they may be looking to exploit the flaws in indexing, but they’re not doing so with any consistent success.
The returns on the smart beta funds is inconclusive at this point. Michael Rawson, a Morningstar analyst, told the Financial Times, “There are a lot of funds here that have underperformed, but the main takeaway here is that your mileage may vary — there is no guarantee that you are going to consistently beat the market. There is no free lunch with strategic beta.”
They’re basically nothing but a theory. An unproven theory at that.
That, however, hasn’t stopped investors from plowing money into them.
These funds once attracted just $100 billion in assets back in 2008. A tiny fraction of the $13 trillion mutual fund universe.
Today, these funds now have more than $500 billion in capital.
We believe “smart beta” are going to be the next hot thing in the markets. And with time, that $500 billion will be in the trillions.
Honestly though, I’m not buying it all. It’s giving away all of your advantages as an investor.
That is to choose individual stocks that meet highly specific criteria. A fund manager with $10 billion in capital doesn’t have that priority.
Even Warren Buffett would bet these “advanced” strategies, despite being very attractive, in theory, aren’t offering what you can achieve far more simply and cheaply.
Don’t fall for the hot new thing when the old can and often will do far better.